Monday, February 13, 2012

Ignorance Is Bliss

    It seems mutual funds are once again in the cross-hairs of market timing professionals.  They always seem to be a popular target when the market fluctuates between extremes and I can’t really figure out why.  I assume those attacking mutual funds need the dramatics to help make their own content more interesting for viewers or readers.  Quite honestly, I don’t get the joke.
    Over the last 12 months, several financial news anchors have repeatedly found laughter in the fact that the average mutual fund does not outperform the market, and has seriously criticized mutual funds for being “long” only.  For those of you that don’t know, the term “long” simply means that you actually own an asset such as a stock.  Whereas, the term “short” refers to an investment that is not owned but rather a bet has been placed against that asset in belief or hope that it will go down.  The continuous barrage of insults upon the mutual fund industry bothers me because some of the people launching these insults were very successful mutual fund managers, and admittedly, they were “long” only managers.
    I realize that in today’s world the concept of actually owning an asset or being “long” for future growth is considered a stone-age concept.  However, I would suggest that professionals in the financial media consider their audience when making such comments.  Are they suggesting that the average investor should throw out the idea of owning a professionally managed mutual fund?  Or perhaps they are suggesting that you should borrow against your current assets to short a particular stock.  I believe the amount of traders parading in and out all day long on the financial networks forget that they are not just speaking to fellow traders.  Unfortunately, many viewers take their words as Gospel.  This leads to destructive investing, and I wish it would stop.
    Whenever I hear such bold suggestions or ridicule it always stimulates my mind.  Based on the so-called "expert" theory that a “long” only manager is handicapped because of their lack of vision or ability to “short” the market, I then began to wonder what managers would be considered the most handicapped of them all based on this theory?  My mind went directly to sector mutual funds.  You talk about being handcuffed!  Not only are the majority of these managers “long” only but they are even more restricted because they cannot step away from a specific sector;  no matter how out of favor that sector may be at the time.  For example, do you think a financials mutual fund manager felt very good about his or her performance last year? Probably not, but they could not step away.
    I decided to look at some numbers myself assuming that the severity of the handicap these managers endure will show up in the data.  I examined a portfolio of an equal investment made into mutual fund managers that covered each of the eleven major sectors within our economy.  My data began at the beginning of the “Lost Decade” and concluded at the markets close on February 10, 2012.  Here are the sector mutual funds I used and their results when compared to the S&P 500 Index:

Technology (Allianz RCM Technology Fund symbol: DRGTX)
Consumer Discretionary (Fidelity Select Consumer Discretionary symbol: FSCPX)
Financials (Davis Financial Fund symbol: RPFGX)
Telecommunications (T. Rowe Price Media & Telecom Fund symbol: PRMTX)
Industrials (Fidelity Select Industrials Fund symbol: FCYIX)
Utilities (Franklin Utilities Fund symbol: FKUTX)
Natural Resources (Fidelity Select Materials Fund symbol: FSDPX)
Real Estate (American Century Real Estate Fund symbol: REACX)
Healthcare (Prudential Jennison Health Sciences Fund symbol: PHLAX)
Consumer Staples (Rydex Consumer Products Fund symbol: RYCIX)
Energy (BlackRock Energy & Resources Fund symbol: SSGRX)

SectorPortfolioS&P 500
Trailing 12 Mos+2.39%+3.15%
3-Yr Avg. Annual Ret+25.26%+20.05%
5-Yr. Avg. Annual Ret+4.28%+.70%
10-Yr. Avg. Annual Ret+10.89%+3.87%
Since 1-1-2000 +10.98%+1.11%/

    Does this portfolio look like it was hampered by having to be both “long” the market and stay within specific sectors?  If this is handicapped, then sign me up!  In the end, professional money management and diversification still hold a tremendous amount of value.  The problem is that diversification and asset allocation are quite boring to talk about.  When you are trying to sell ad space you better be delivering some type of dramatic commentary.  It seems people are more interested in who can shout the loudest and be heard instead of the quality of what is being said.

    I would like to now address the fact that the average mutual fund lags the overall market.  While I know this to be true I don’t quite see why it should matter.  Let me put this argument into context for you in a couple different ways that are more relatable.  The first example is a classroom that consists of five students who are all considered geniuses.  Now let’s assume that classroom is growing in size.  Instead of 5 students there are now 10, and then 15, and then 40.  The larger the class room size becomes the more average the performance of the class becomes when looked at as a whole.  When it comes time for the “Academic Bowl” which students do you think the professor is going to pick to be on the team?  The same is true of the mutual fund industry.  The fact that more and more mutual funds come on to the market, which makes overall performance average, does not mean that the high quality managers are difficult to find.

    “Fantasy Football” has become a national craze.  I have to tell you, I don’t understand how people come up with enough high quality players to draft and start in their fantasy league every week.  After all, when you look at the average performance per player in the NFL it is not very impressive.  How could the average performance be impressive when there are 32 teams in the league, suiting up 45 players per team for every game?  That is 1,440 players taking the sidelines every weekend.  Yet fantasy football league owners are still able to find around 7 high quality individuals to start each week.  They do not care about the average performance data per player for the entire league.  Just as I do not care about the average statistical performance of the mutual fund industry when I know the sample size is so large.

    In the end, your allocation and maintaining that allocation is more important to your long-term success than following some haphazardly recommended trading strategy that was probably not meant for your ears.  We cannot force the message to change but we can change the way we react to that message.  I wish I could hire some the retired fund managers turned news anchors to manage a portion of my assets in the same "long" manner in which they had so much past success.  I can't because they are retired.  My only hope is that they stop campainging as if they are still fund managers seeking assets and start taking into consideration who may be listening to their every word.

Thank you and good luck everyone.

Jon R. Orcutt, founder of Allocation For Life, is an asset allocation strategist and author of “Master the Markets with Mutual Funds: A Common Sense Guide To Investing Success”